The Importance of Financial Ratios

Financial ratios are useful tools that help business managers determine a company's performance.

Financial ratios are created from financial statements to gain meaningful information about a company’s performance. The numbers found on a company’s balance sheet, profit & loss (or income statement), and cash flow statement can be used to perform quantitative analysis to show a company’s liquidity, leverage, growth, margins, profitability, rates of return, valuation, and more.

These ratios can be used to analyse a peer group to determine the average rate of profitability of a particular industry. Managers of a firm should use these to determine how well their performance is compared with managers in similar situations. 

It’s important for any sales team to understand how their value proposition can potentially change a client’s financial performance (and therefore ratios). I would therefore suggest any sales pitch worth listening to has at least some financial element to it. 

To start you off I have listed some of the most important financial ratios in this blog post along with how to calculate them and what they show, no single measure should be used to define the financial performance of a firm. If you think I’ve missed any feel free to add your own in the comments section.

Ratios that you must calculate at regular intervals in order to assess how well your resources are utilised

Analysing Performance

Business performance indicators, also known as key performance indicators (KPIs), are quantifiable measurements used to determine and track the economic health of a business. Created from publicly available information they are tools for internal and external stakeholders to identify how well the company is doing, especially in regard to competitors and identify where strengths and weaknesses are.

These are very helpful tools for entrepreneurs to determine how much value their own team is adding to their business and how much value your service will add to your customer’s business.

Return on Equity

Profit After Tax / Shareholders’ Funds

Shows the performance of shareholders investment. Can be useful to compare with other investments such as dividend yield in other companies or return paid via bank account.

Return on Net Assets

Profit before interest and tax / Net assets

Shows the performance achieved regardless of the method of financing. Sometimes called return on capital employed. A high number here means that the company is using its assets and working capital efficiently and effectively.

Tax Ratio

Tax / Profit before tax

The proportion of profit which is absorbed by tax. 

Profit Margin

Profit before interest & tax / Sales (revenue) 

Simply put it shows profitability. 

Net Asset Turnover

Sales / Net assets

Show the efficiency of a company’s assets to generate revenue or sales. Comparing the amount of revenue to its total assets. 

Fixed Asset Turnover

Sales / Fixed Assets

Fixed assets are tangible assets (things that you can kick). This shows how efficient a company is using them to generate sales. 

Stock Turnover

Cost of sales / Stock

Shows how quickly goods move through a business. If you multiply this number by 365 it shows stock days on hand. 

Debtor Turnover

Sales / Debtors

Shows us how quickly debts are collected. Multiple by 365 to get debtor days.

Financial Ratios

Help you to determine the financial strength of a business.

Financial ratios are created from a company’s published financial information and are used for comparison purposes. Also helpful for small business owners and managers to help to measure their progress against predetermined internal goals, a certain competitor, or the overall industry. Ratios will be used by bankers, investors, and business analysts to assess a company’s financial status.

If you’re ever needed to speak/pitch your ideas to someone with a financial background some knowledge of these will be appreciated and help you to stand out from the crowd.

Debt Ratio

Debt / Capital employed

Shows how solvent a business is. The proportion of the business which is financed by debt (the balance being financed by shareholders). Can also be measured as Debt / Shareholders funds

Interest Cover

Profit before interest & tax / Interest paid

Does the company generate enough profit to cover the interest payments on it’s debts. 

Current Ratio

Current assets / Current liabilities 

Shows the extent to which short term assets cover short-term liabilities. 

Acid Test

Debtors & cash / Current liabilities

The extent to which liquid short term assets cover short term liabilities. 

Stock Market ratios

Stock Market Ratios

Although there are a wide variety of stock market ratios available, the ones I use the most (in the context of analysing customers) are the ones below. Namely, earnings per share, price to earnings ratio, dividend yield and the dividend cover.

These along with the share price are sometimes used in senior team’s remuneration packages, so if you can improve them – happy days.

Earnings per Share

Profit after tax / Number of ordinary shares in issue

This divides net earnings available to shareholders by the average outstanding shares over a certain period of time. The formula indicates a company’s ability to produce net profits for common shareholders.

Price to Earnings

Market price per share / Earnings per share

Broadly speaking shows the current investor demand for a company share. A high number indicates high demand from investors. Expressed in years, interpreted as the number of years of earnings to pay back purchase price.

Dividend Yield

Dividend per share / Market price for the share

Expressed as a percentage, this shows how much a company pays out in dividends each year relative to its current share price. 

Dividend Cover

Earnings per share / Dividend per share

This shows the number of times the current dividend could have been paid out of earnings.

Richard Brooks is the CEO of UK based Language Service Provider K International. Having spent 25 years+ in the language industry he is an executive board member for the European Language Industry Association and is a former executive board member for the Association of Language Companies. Richard holds a triple accredited MBA from Cranfield School of Management majoring in economics and finance. He has developed numerous international educational programs and written several publications on topics of interest. Richard recently sat on the UK government-initiated trailblazer group, created to set standards of professional sales practice in the UK. He is now a Director of the Key Account Management Forum, a leading centre for research and best practice in strategic sales. In addition Richard is an active investor and business coach for the localization industry. Through this work he has helped several entrepreneurs create winning strategies, develop their senior teams and achieve their goals.

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This is my blog. On it I’ll be talking about business frameworks, models and techniques.

I’ve spent 30 years in business management, the last 25 being in the localisation world. I’m now the CEO of K International and executive board member for the European Language Industry Association (ELIA). During my time in business I’ve worked in Operational, Creative and Sales roles on projects small and large.

I’m an Exec MBA from Cranfield School of Management and have participated in numerous international educational programs. Recently I sat on the UK government-initiated trailblazer group, created to set standards of professional sales practice in the UK.

Now an active investor and business coach for the localization industry. I help entrepreneurs create winning strategies, develop senior teams and increase the value of their companies.

If you have a project which would fit my skill set please reach out to me via the contact information on this blog or send me an email.

 

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